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Global equities

Stockpicking without subjectivity

After the great financial crisis of 2008, the US economy evolved through both remedial and recovery phases, and is now advancing into a new era.

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After the great financial crisis of 2008, the US economy evolved through both remedial and recovery phases, and is now advancing into a new era. The new environment, we believe, will pose challenges as well as offer rewards for stockpickers.

Not for 36 years, since the election of Ronald Reagan as the 40th president of the United States in November 1980, has there been similar political and policy uncertainty. The market reaction to the election of Donald Trump as the 45th president was initially one of euphoric expectation around anticipated policy changes (lower taxes, massive infrastructure spending) that are expected broadly to support equities. However, much of this reaction was based on assumption, while the missing ingredient was fact. How Trump’s policies will play out in practice, given opposition in Congress, is yet to be revealed.

DON’T MAKE BINARY BETS

Over recent years, making investment decisions based on political and macroeconomic forecasts has been a fraught enterprise. In early 2016, few would have predicted that a few months later the UK would be on its way out of the EU and the US would have Donald Trump as president. Nor would many have predicted the positive response of equities to each event. History is littered with failed macro predictions. Similar macro events have often had contrary market outcomes.

Last year was a sobering reminder of the follies inherent in forecasting future binary macroeconomic events, to say nothing of trying to anticipate the impact of those outcomes on financial markets. While disruption and dislocations within the market can widen the opportunity set for active equity managers, they can also include periods of irrational and seemingly anomalous behaviour.

So let us not make the same mistake by predicting the market outcome of four years of a Trump presidency. There could be stimulus from tax cuts and massive infrastructure spending, and there could be shocks from trade wars or political upsets. We may be safe in saying that the Trump presidency is likely to have its fair share of surprises.

THE PATH TO PASSIVE

Of course, traditional stockpickers have long eschewed a top down, or macro forecasting approach to investment decision making, in favour of a fundamental or bottom-up approach. Yet traditional stockpickers have often had disappointing performance, especially relative to benchmarks in the US equity market. Faced by the challenges of economic and investment forecasting, many investors have turned to passive or index tracking strategies. Inflows into US equity index trackers and ETFs are more than US$1.4 trillion since 2007, and outflows from actively managed US domestic equity funds are US$1.2 trillion[1]. According to EPFR, almost US$65 billion has flowed into passively managed US stock funds this year. Actively managed funds have suffered redemptions of US$47.6 billion over the same period.

UNANTICIPATED CONSEQUENCES

However, the size of fund flows into passive trackers of market capitalisation-weighted indices itself has profound market effects. Currently, leadership within the S&P 500 index remains extremely narrow, which we believe may be a by-product of the increase in popularity of passive investing. During the year to date, advances in the US$22.6 trillion benchmark S&P 500 have relied disproportionately on the performance of a small percentage of underlying constituents. Ten stocks in the index, including ecommerce behemoth Amazon, have contributed roughly half of the S&P 500’s gains this year to date[2]. The top 10 contributors predominantly sit within the technology sector, which has advanced 12.6% so far this year[3], outpacing other sectors. Companies like Apple will receive bids from multiple ETF buying bases, including those that track the S&P 500, the Nasdaq 100, and the broader technology sector. Currently approximately US$2 trillion of assets directly track the S&P 500, while US$7.5 trillion to US$8 trillion use it as a benchmark. The challenge for active investors will be to differentiate how the market impact of these flows reflects the underlying fundamentals of the economy, or if they do at all.

AVOIDING BIAS

We would argue that active management has a bright future if intelligently pursued. Traditional active fund managers’ underperformance often has its roots in investment style bias, we believe. Some active managers are tilted towards a value style, seeking bargains, whereas others are skewed toward a growth style, seeking companies with impressive performance; yet neither style works for all seasons. We believe consistency in return structure to be crucial in controlling portfolio volatility, and that the ability to remain nimble and fluid when deploying stock selection techniques is vital.

[1] According to data from the Investment Company Institute, Simfund, and Credit Suisse, as quoted in the Financial Times, 24 January 2017.